Bob Lee’s goal for the Sentinel Mid Cap Growth Fund (SNTNX) has been to achieve above-average performance, whether conditions indicate the overall market should be climbing or falling, since he took over the fund’s management in 1993. Although Sentinel Mid Cap is based in Montpelier, Vermont, rather than one of the nation’s financial hubs, that hasn’t hurt its performance relative to its peers. According to Standard & Poor’s, for the last 10 years, the fund has had an average annualized return of 9.8%, while the return for its style peers was only 8.6%. It’s also outperformed that group for the one- and three-year periods, although the five-year numbers are somewhat disappointing (0.43% vs. 1.83%). In September, S&P increased the overall rating for the fund from three stars to four. Through the first week of December 2004, Morningstar had the fund’s trailing return at 8.73% versus 0.69% for the S&P 500. Lee seeks to keep the fund fully invested; he often has less than 1% of the fund’s assets available as cash. At its best, Lee’s portfolio is reminiscent of the classrooms in Garrison Keillor’s Lake Wobegon, where all of the children are above average.
What’s the investment philosophy behind the Sentinel Mid Cap Growth Fund? I’ve been managing the fund now for 11 years. The investment approach we take is to look for some key overall portfolio characteristics in terms of stock selection. What we like to deliver is a portfolio that has, on average, above-average projected earnings growth, above-average return on equity, and a below-average PEG ratio, which is the P/E to growth ratio. The way we get there is by using a combination of quantitative and fundamental approaches and processes. We compare ourselves in terms of an index to the Russell Mid Cap Growth Index. We start with that universe, although we really screen against the universe of all mid-cap stocks, which can total as many as 3,000 stocks. In the first step of the process, we use a screen, a multi-factor quantitative model, to help us narrow down that entire mid-cap universe to a manageable number of names. Included in that screen are some of the characteristics that I mentioned. We look for high return on equity, high growth rate, high return on capital, positive earnings revisions, a positive earnings surprise, and a relatively low PEG ratio. That helps us narrow down the field to about 300 or 400 names, at which point we use our fundamental analysis and go through the names in more detail to try and figure out if there’s anything that the initial screen might be missing, [to discover] what’s really behind the numbers.
We ask if their margins are as strong as they appear and are they sustainable. Is their industry position strong? Once we get through that process, we generally end up with a list of about 150 names that we can use in the portfolio. Those names then go through some evaluation analysis, which is the last step. There we do some dividend discount models and challenge our assumptions using some conservative growth rates and conservative terminal multiples. Finally, we arrive at a list of names that can actually go into the portfolio, having gotten through the initial quantitative screen and through the fundamental screen and then finally through the valuation screen.
If you come up with 150 possibilities, how many stocks are there in the portfolio at any given time? We range anywhere from 80 at the low end, I’d say, to 120. Right now we’re pretty much in the middle of that range, just over 100 names. We also apply some top-down risk controls on the portfolio in that we limit our sector overweights or underweights to no more than plus or minus 33% of the major sectors. For example, if technology was 30% of the index, we would not be more than 40% or less than 20%, which is plus or minus one third of the index weight. We also do some analysis on a regular basis that helps us eliminate mistakes quickly. We look at any stocks that are underperforming on a quarter-to-date basis by 10% or more versus the index; those get immediate attention. We either make a decision to add to those positions or to eliminate the position. This is to prevent us from being dragged down holding onto a losing position. We do it on a quarter-to-date basis and a year-to-date basis, so it’s a daily review. We’re always looking at where things stand on those two measures.
You were into tech stocks when a lot of investors were feeling gun-shy about technology. Talk about your approach to technology and high-tech stocks. By way of background, I would say that the bulk of our strong performance over the last three years–and we’re in the top quartile against Morningstar’s mid-cap growth universe–has been through stock selection, which has come through this process. We have had the opportunity to add value through our sector weightings and our industry weightings and in technology in particular. It’s such a cyclical and wide-swinging sector of the market that some timely moves in that sector can really pay off. For example, in 2002, which was a big down year and a tough year for technology, we were underweighted in that sector in general and in semiconductors in particular. In 2003, we saw a stronger economy in the making with the benefit of the tax cuts and the child tax credit. The fact that the Administration generally wanted to see a strong economy, we felt that the market was going to anticipate a strong recovery in earnings. We wanted to be in the more cyclical sectors of the market, and technology, probably being the most cyclical, was one of our overweights. So we were overweighted in semiconductors and technology throughout all of 2003 and there was a very nice contribution [to the fund's performance] from that position.
Toward the end of the year, our feeling was that maybe things were getting a little bit ahead of themselves and we had pretty much fully benefited from the run in technology, so we entered 2004 at an index weight, or slightly under, in semiconductors. That again paid off because tech started the year weak and was one of the poorest performing sectors in the first half. About the end of September, we started to move back into the semiconductor names, since we felt they were becoming one of the most hated sectors of the market. Almost every Wall Street analyst had finally given up and folded the tent on this industry. It’s a tough sector to call, and often the best time to make your move is when the consensus is strongly negative, because these stocks tend to anticipate what’s going to happen six to nine months out. We did make that move and I can’t say that it’s been a big benefit so far [about a month later], but the stock has had a nice bounce since then, and we still think we’re positioned to do well when this sector goes back into favor in 2005. We think semiconductor equipment orders will bottom out in the next six months or so and that the stocks will do well in anticipation of that over the next six to nine months.
I noticed that Dell is one of your big holdings. Do you think there’s still a lot of growth for them in the PC market? There’s not a lot of room for growth for unit bases in the U.S., but I think their model is unique: They are clearly the low-cost provider. I think Dell’s going to continue to gain share very nicely, taking share away from Hewlett-Packard especially. I also think Dell has a lot of room to grow internationally. It’s making some nice gains in Europe and it’s one of the bigger players in Asia. It’s more of a market-share game in the U.S. and then expansion of the [overall] market in Asia and Europe.
Dell’s really not so dependent anymore on PCs; it’s becoming more of a server company. That’s where a lot of the growth is coming from now.
I also understand that you’re very interested in some of the Internet companies. Yes, that was one of our better-performing sectors in 2003 as well. When we were overweighted in technology, we had some very nice moves in Yahoo!, eBay, and even Amazon.
The thinking in the case of Yahoo! was that we saw a trend moving away from print advertising and more toward Internet advertising; Yahoo! was a clear beneficiary of that. We saw Internet usage as continuing to move up, even though the general perception was that usage had topped out. So it seemed like an opportunity to take advantage of those two strong trends. eBay has been a long-term holding. It’s a unique franchise and it’s just so well positioned to be able to benefit from growing volume without having to make an investment in inventory. e-Bay is basically a service provider to a very large auction market.